Sunday, September 14, 2014

The Need to BUY Now


I have a belief that for the moment we are in a melt up phase which is short of the type of parabolic explosion that signifies a generational top. Further, I believe that in general we have moved from a fairly valued stock market and are on the way toward a fully valued market. Thus, I have been focusing on reducing the opportunities to take large risks of losing substantial capital. I have not, however, devoted as much space in these posts to all the different types of risks there are out there. The quotable Howard Marks of Oaktree Capital, a long-time user of our performance data, has produced another one of his great letters where he has enumerated 24 risks which show the breadth of ways to lose significant chunks of capital.

Nevertheless, a number of professional investment managers feel compelled to buy some positions now. Some may be sensing a “bandwagon” surge on the part of their clients to more fully participate in the melt up. Others have picked up my view to look for unconventional investments. Still others have devoted too much effort on avoiding losses over the years and now need some new winners. These feelings need to be corralled under a term similar to the one that earlier drove investors into the market which was TINA (“There Is No Alternative”) to assuming risk and enter the market. The new term suggested by Howard Marks is FOMO (“Fear of Missing Out”).

A buy a day

I believe that on any given day that there is a security someplace in this world that represents a real bargain. However, to paraphrase Jason Zweig’s excellent interview with Charlie Munger in this weekend’s The Wall Street Journal, one must recognize the extent of one’s circle of competence and not stray beyond it. Further, Mr. Munger has said that patience is needed. He has gone through a period of years without adding a new name to his roster of investments. Charlie’s innate wisdom may be greater than mine, but I am willing to suggest areas that professional investors should examine as long as they are within their own circle of competence.

Framework for seeking new names

My preferred search procedure rests on my introduced Lipper Time Span Portfolio concept. This concept rests on four independent portfolios which may contain funds or individual securities. The four time spans are the Operational Portfolio to provide the next two years of funding. The Replenishment Portfolio which is designed to renew the funding capability of the Operational Portfolio within five or so years. The Endowment Portfolio is to cover the currently identified longer-term needs of the major beneficiaries. The fourth and ultimate portfolio is the Legacy Portfolio which is to produce capital for spending beyond the grantor or initial investor. Typically the Endowment Portfolio is to cover a time span of more than ten years or beyond the competence of the existing investing decision makers; while the Legacy Portfolio, if desired and well managed could be, in effect, a perpetual portfolio.

With the time spans in mind, I find it useful to make some general predictions of the currently likely investment environments in each of the four time spans recognizing the old quote of “Humans Plan and God Laughs.”

At this point in time I believe that the Operational Portfolio will struggle with below historic interest rates which at very best may reach double current rates.

The Replenishment Portfolio should expect at least one major market melt down of at least of 25% and if the current melt up goes parabolic, 50% or possibly more.

Assuming that the market is in a form of recovery by the time the Replenishment Portfolio has done its job, the Endowment Portfolio should be moving up in a cyclical fashion over its life, averaging an inflation adjusted return on equity for stocks and a “real” rate of return similar to returns on capital employed by the general economy. The Legacy Portfolio will largely be driven by the disruptive forces unleashed by technological and sociological changes.

While I would prefer to focus on the longer-term portfolios, my investment management friends and I need to perform well with the first two portfolios or we won’t be given the opportunity to direct the two other portfolios.

Looking for short-term winners

If we were in “normal” times with interest rates tied to credit concerns and inflation, high quality short-term paper would be earning in the 4-5% range which could easily acquit the funding requirement. The so-called riskless investment in US Treasuries can’t do it. My suggestion is to research within your circle of competence the following unconventional thoughts:

1.     In August there were a number of currencies which gained 1% which could be of interest; Norwegian Krone +1.42%, Malaysian Ringget + 1.39%, South Korean Won +1.37%, Brazilian Real +1.24%, and Mexican Peso +1.01%.

2.     Very selected Commodities; Cotton +5.89%, Natural Gas +4.75%, and Aluminum +4.74%, all for the month of August. I would not recommend Livestock +11.45% gain year-to-date or shorting its corollary, Grains -11.28% year-to-date.

3.     Not immediately but in time, one should also select, high quality municipal bonds which are likely see their interest rates go up when newly issued. The banking authorities have ruled that these issues can no longer be counted as High Quality Liquid Assets (HQLA) for bank reserves' calculations. Combine this news and the fact that banks are being forced to cut back on their trading desk’s Muni positions. This means that there will be fewer buyers of this paper particularly at a time that the US needs to dramatically improve its physical and educational infrastructure. Demand for financing will force interest rates up.

4.     Bank loans recently shunned because of fears of a recession may well be priced attractively if we are entering a slow down, not a recession.

Searches for the Replenishment Portfolio

The next five years or so are likely to be difficult for portfolio managers. The melt up momentum will drive a lot of stock prices higher, but one needs to be careful with some biotech and new small companies being priced generously. Focusing on firms which are spending their excess funds wisely to build competitive advantages might be prudent.

Because we believe in the rising capabilities found in many emerging markets we have a number of investments in these kinds of funds for our Endowment and Legacy Portfolios, but I would not be adding them into the Replenishment Portfolio now as these stocks have led in seven of the last ten and half years.  Most of the flows into this sector come from institutionally-driven ETFs (Exchange Traded Funds) which added $3.5 billion in August compared to the much larger and more conservative mutual funds which added only $1.8 billion. Our financial services private fund is doing better recently by not being burdened by deposit-oriented banks.

Question of the week

Where are you finding stocks to buy for the short term (five years)?
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Contact author for limited redistribution permission.

Sunday, September 7, 2014

Six Probable Investment Mistakes


Recently I read a quote which said experience is what others call mistakes. As we are all humans, we make mistakes. Progress is made by learning from mistakes. Often when I meet with another investment manager who has had some completed mistakes I ask what he/she has learned. Some complain that they were lied to by various sources or that some major unforeseen forces occurred. I would invest with these types of managers only if I was convinced that the future would duplicate the past, an unlikely event. I am much more likely to invest with a successful manager that has had some mistakes and who has upgraded his/her processes to avoid similar mistakes in the future.

I believe that the job of good analysts is not to merely be detailed reporters, but to be looking for future changes or more likely, mistakes from which to benefit.

Our job should be to look into the shadows of oncoming events with reference to past shadows. Notice the focus on shadows when there is the absence of hard, clear facts.(Shadows have three elements-a candle or light source, an objective to be projected, and a reflection on one or more surfaces.) The size of the reflection can be measured, but it can not be understood without knowing the length between the light source and the object and the object to the reflection. The key is not to stop there but guess what is not visible in terms of the other sides of the lit up objective.) My self appointed task with this post is to look at what I believe to be the causes of future mistakes by extrapolating what is known.

The six mistakes that I will focus on are: 

1.    The KISS Principle 
2.    Static thinking in a Dynamic World 
3.    Elusive Liquidity 
4.    Masquerading Earnings 
5.    Non cash generated dividends 
6.    Comfort in Conformation

1.      The KISS Principal

Marketing people traditionally look for short “snappy” communications with prospects. These instructions to portfolio managers and analysts can be summed up as KISS – Keep It Simple, Stupid. Others prefer the “elevator pitch” which can encapsulate the salient pluses about a recommendation that takes no longer than the time the elevator travels from the lobby to the prospect’s office or in reverse if the client is going to be entertained outside of the office. While both have the virtue of brevity, they run the chance of failure to communicate the essential risk of disappointment which can come back to haunt the (sales) pitcher in court. Yes, we need to be able to transmit complex topics quickly, but with appropriate balance. All one needs to do is to ask someone or institution about a meaningful loss to learn the failure of a KISS statement or elevator pitch.

2.      “All Other Things Being Equal”

Often the way economics and/or finance are taught is by using a standard XY chart of supply and demand. Where the two slopes meet is the equilibrium price point. In a perfect world this might be accurate. But in a world where there are capable marketers and traders on each side plus other external impacts to a marketplace, transaction prices will be caused to shift. To do away with these unpleasant realities the presenter will state, “All other things being equal,” something explainable will happen. In truth we live in a dynamic world where factors are changing every moment and therefore we rarely get to the condition of all other things being equal. Static thinking rarely works in a dynamic world.  Wise investors today should expect conditions to be in a state of flux. Thus, we attempt to weigh the potential market or price power of buyers, sellers, and main changes of conditions.

3.      Elusive liquidity

Based on the fact that the average sized transaction on the New York Stock Exchange is 250 shares or less the ability to exit a market position at a reasonable price relative to the prior sale can be difficult. The “Silicon Traders,” actually the speedy computers in the hands of high frequency traders and others, have dried up the ability to safely move large blocks during normal markets. In periods of extreme price and volume movements the computers are driven to suspend current trading. To offset some of these risks HFT (High Frequency Traders) use stock futures. In so doing, they have forced the price of futures to rise to such a level that, according to BlackRock, many of the trading institutions are using ETFs (Exchange Traded Funds) as a cheaper substitute with assured execution. Rarely has the imbalance in ETF trading led to the spread between the bid and asked prices to widen so materially or in rare cases, suspend trading.

The bond market is a substantially larger market with many more discrete issues.  It faces a series of challenges to provide liquidity in an over-the-counter market dealing with panicked owners of both highly leveraged positions and stable owners of large bond holdings. With these concerns in mind I urge all investors to be conscious of significant bond market volume disruptions which could cause equity prices to gyrate. Liquidity can always be purchased, sometimes at a very high price.

4.      Masquerading earnings

The soothsayers trying to calm equity investors speak about valuations that are not out of line with their past histories. In the past most companies’ earnings came from domestic operations. Today’s earnings are increasingly being generated overseas and there is no recognition as to the increased taxes that would have to be paid if those corporate activities had to be brought back into the US. In some companies that sell products a good bit of earnings are coming from their net interest income for subsidizing their sales. At any rate these types of earning are not worth the same valuation as those coming from manufacturing and servicing clients. 

Today a measurable portion of earnings per share is a function of stock buybacks which lower the number of shares and therefore raising earnings per share, not a useful measure of growth and valuation on the growth achieved. Of the funds that we invest client money into we ask that they discuss with us the operating earnings production including their source. This leads to a general view on our part that valuations are moving beyond fair price, but not yet at historically full price.

5.      Non cash earnings-generated dividends

As with the rest of the investment world, some of our clients want dividend income even in this 2-3% environment. This is particularly true for our foundation clients who use the generated income to do the good deeds they do for those less fortunate. I have two concerns with this stream of income and its market value.

First, due to our out of touch corporate tax structure many companies are retaining their outside of US earnings overseas and borrowing to be able to pay domestic dividends. Their official payout ratios don’t look out of line on the surface, except if you look at my concerns expressed about reported earnings above. If domestic earnings do not improve and there are no tax changes, the cost of future dividends will become higher and could cause the rate of dividend growth to be curtailed at the very same time that recognized inflation goes up which will put a squeeze on our foundations' ability to deliver those important good deeds.

The second concern can be characterized by the fact that years ago one of the advantages of a good dividend paying stock was that its yield was in the neighborhood of high quality bonds and thus would lose materially less when stock prices went down. I expressed this theory to an elder, more experienced member of my family when a particular stock in question was yielding 5%. He smiled as he said that in all likelihood the 5% yielder could reasonably hold its value for a couple of days at best and after that would fall in line with other stocks of reasonable to high quality. He proved to be correct. Thus, the current 2-3% yielding stocks are not giving the foundations much in the way of downside protection. My current view is that these accounts should be managed on a total return basis and we should supply the needs from an Operating Portfolio (OPERPOR) part of our Lipper Time Span Fund Portfolio concept.

6.      Comfort in conformation

Jason Zweig in an always interesting weekend column in The Wall Street Journal noted that humans tend to be more comfortable conforming to what other humans are doing. This probably comes from our prehistoric needs to gather for self defense. From an investment standpoint the history of attempting to hug the middle of the movement can be less satisfying and at times expensive. As a graduate of a US Marines Corps Basic Officers School I observed that bunched up troops were good targets for the enemy, thus the need often to move in single file as we progressed.

Actually I started adopting this principle when I was one of the worst fencers on the Columbia College championship fencing team. When I had lunch with the current fencing coach last week, I observed that when fencing a better athlete who was classically trained, I could score points with unconventional tactics.  I was pleased to learn that the current coach got a gold metal in the Junior Olympics following a similar pattern. I firmly believe that there are times when it pays to be unconventional. This may be the time for you to be unconventional, as many investments are correlating closely so that they are on parallel courses which do not give investors much in the way of protection against reversals. Bottom line: When too many are participating someone is likely to get hurt. Some well chosen and well timed unconventional moves could be the most prudent of all strategies.

Question of the Week
What are the investment mistakes that you have learned from the most? Please share in private. 
Did you miss my blog last week?  Click here to read.

Comment or email me a question to  .

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, August 31, 2014

Labor Activity Needs Protection


The nature of humans is to labor to make better and safer lives for themselves and their families. The unfortunate image coming out of today’s school systems and many of its union-dominated teachers is that manual labor and skilled labor by employees is to be celebrated only on Labor Day in the US and similar holidays elsewhere.

I see labor all around. Certainly the homemaker producing meals, keeping house, and often serving as the household purchasing agent is laboring. Laboring also are the portfolio managers who are acting, along with others, as stewards for the retirement funding of employees. Many of these put in more hours than some that are punching a time clock or equivalent.

On Labor Day 2014, I think we should be thinking about how to make all that labor a better value. At the first level we should see how to improve unemployment and under-employment. At the next level we should be paying attention to retirement funding. Finally, almost all laborers desire to take care of beneficiaries after they are gone. This post will share some of my own thoughts on each of these topics.

Mismatched openings and job seekers

As someone who speaks with various employers and particularly entrepreneurs about their future progress, I often learn about the need to fill particular positions within their organizations. Often they cannot fill existing (or more importantly new positions) not because applicants don’t have the required skills. If the employment decision was left to a computer match procedure, it is estimated that all or almost all the roughly four million job openings would be filled very quickly. But that is not the case when are faced with hiring fellow humans.

I don’t know where so many of these applicants get their work-related attitudes; whether from their families, friends, or their teachers. The first hurdle is that the world or others owe them a job. The second is that they have pre-conceived notions as to the conditions of employment which they think they should dictate. In many cases they do not grasp how a commercial organization functions to provide what the clients expect and need. Too often they anticipate that their co-workers will make room for them and coach them on the first day as to how the work and social elements really work.

I believe that everyone within an organization is a salesperson meant to convince every contact that his or her firm is absolutely the best organization to meet people’s needs. We are all involved with sales and service. People who want to join a firm need to feel loyalty to the firm, its customers, managers, and fellow employees. The sad truth is that there is not enough of these people, thus a number of the openings will not be filled.

The cost of vacant jobs

The economic and financial impacts of not filling the vacancies are significant. As long as people are unemployed the cost to the society will be high in terms of taxes paid and more significantly a shortfall in consumer purchases. There are also, at this time, important investment implications to the unfilled openings. Organizations will not be operating at optimum productivity levels. Profit margins will be less than what they could have been. Today there is concern that profit margins, not profits, have reached record levels. If these slip, even with higher sales generated profits, the valuation afforded these stocks will decline, as they will be viewed as more cyclical and thus could lose their place in some portfolios.

Profit margins are under pressure in numerous employers and particularly in health and financially oriented concerns today. Due to increases in compliance and supervisory responsibilities, companies are being forced to hire good but unproductive people in terms of bringing in more sales. This is hurting existing margins. When we combine these pressures with much more restrictive activities mandated for the financial community the results are significant layoffs at numerous banks and other financial firms. Major clients are already seeing a decline in the levels of service and supervision. I suspect that this trend will continue unless there are major changes in regulation.

Retirement funding awareness

One of the potentially major upticks for labor in the US is the ability to influence its own retirement funding. The switch to Defined Contribution plans from Defined Benefit plans can produce a retirement account that more closely represents what the specific employee wants from the available alternative options rather than being bundled with all other employees. The various 401(K), 403b and 457 plans leave the responsibility of choice to the individual. These plans need to be carefully constructed in terms of levels of contributions, matches, vesting, fees and expenses.

I am pleased that according to BrightScope, the Number One plan based on these characteristics in 2013 was the Second Career Savings Plan for the National Football League and the NFL Players Association that I have advised as to the construction of nine specific fund accounts.

The reason for the nine accounts was to allow the Players to decide how they wanted their money to be invested, in a collection of mutual funds or separately managed accounts that generally clone their advisor’s funds. Other retirement accounts that we manage are customized to the needs of the employee base. However, all investors including retirement plans are exposed to both stock and bond markets. With that thought in mind, we all should ask whether there are parallels between Labor Day 2014 and Labor Day 1929.

As was noted in The Wall Street Journal, both days had just past the 2000th day of a bull market. In the case of the earlier market it continued to rise in September and started its cataclysmic decline in October 1929 to recover in December but the damage had been done to the confidence in the market and eventually the economy.

Should employees and other investors totally jump out of the market with the belief that they will jump back in at materially lower prices?

The great portfolio manager, Peter Lynch, who built such a great record at Fidelity, is quoted as saying that more has been lost by investors trying to execute such a maneuver than the size of the losses at the bottom. In addition, I would be particularly careful investing substantially in high quality bonds now. Instead of celebrating that the purchasing power of bonds is now stable to perhaps rising which will help the long punished retirees, the central banks such as the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan are very much interested in raising the rate of inflation to spur more risky investment as a way to create jobs. If they are successful, the purchasing power of bond principal and interest will decline. Based on their past record they may not be successful.

Helping beneficiaries

All of us who are looking to the future for the benefit of families and others such as universities, hospitals, and other non-profit groups need to invest over multiple time spans. In prior posts I have discussed our Lipper Time Span Fund Portfolios which are designed to meet the different needs of beneficiaries. With the measurable possibility of a significant market decline sometime in the next five years we have created a Replenishment Fund Portfolio concept (REPPORT) to replenish the capital that will be spent over the next two years to meet operating needs by the Operations Fund (OPPORT).

The Replenishment Portfolio probably has a mixture of equities and fixed income funds or securities with a maturity of five or fewer years. With the recognized risk of a significant decline and Peter Lynch’s warning, a conservative approach is warranted. At this point I would select funds that invest in companies that have relatively little debt but compared to others have high returns on assets, equity, and invested capital.

At the other extreme in terms of time spans, the Legacy Fund Portfolio should be looking into funds that invest in companies that are spending wisely in research and development plus intelligent brand building. If these companies do spend wisely they will be creating the kind of unassailable position often called the protective moat. At that point they should be producing substantial excess capital, fulfilling Warren Buffett’s favorite structure of a company that has both a moat and a fortress. On the way their financial ratios are unlikely to match those found in the Replenishment Portfolio.

Question of the Week:
Where and how are you finding new good people to hire?
Did you miss my blog last week?  Click here to read.

Comment or email me a question to .

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of 

Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.